How Does the Investor Make a Return?

Let’s say I’m a real estate developer and I’m offering you a deal: if you pay me $2 million, I’ll buy a plot of land, build a big house, sell it for $3 million, and split the $1 million profit with you. Sounds like a great opportunity, don’t you think? But you’d have a lot of questions to evaluate the investment before plunking down big bricks of cash: how big will the house be, how long will it take to build, and how much have other houses in the area sold for? Common sense, really. You want to make sure I not only can build a house, but sell it, too, because no matter how wonderful a house it is, until it’s sold, all you’ve got is an empty house. Evaluating a venture deal isn’t all that different.

Remember that until the company is either acquired or goes public (the liquidity event), investors have nothing but an entry on a spreadsheet. (See the earlier article “It’s the Exit, Stupid!”) Startup investments don’t pay interest and don’t pay dividends, and worst of all, unlike investing in public stocks or real estate or artwork or even Bitcoin, we can’t sell or trade it to a bigger fool than us. While the investment might have a theoretical value, since it doesn’t generate income and can’t be sold, it has no actual value until the liquidity event.

A good business is not necessarily a good investment if nobody will want to acquire it, and the converse is true, too; the stupidest business can be a great investment if someone will want to buy it at a premium. As founders we tend to focus too much on how great the business and product are. But the pitch needs to answer the question: is this a good investment? And that comes down to a few simple factors:

  • Probability of reaching a liquidity event
  • How long until liquidity
  • Expected valuation at liquidity

For the vast majority of startups, especially in the B2B space, exit is far more likely to be by acquisition than IPO. So in addition to evaluating whether you can build a successful product, we need to whether there are companies with sufficient cash (or public stock) that would be interested in acquiring the business once you’ve proven it. Despite the inevitable competition, it’s much easier to invest in a startup in a hot space filled with big competitors that have a history of acquiring startups.

When is the right time for acquisition? For investors, it’s as soon as possible, and that means when the startup has achieved sufficient success to attract a big company to acquire it. As a rule of thumb, that means an ARR of $25-$50 million, but is highly dependent on the market: consumer products can be larger, and for pharmaceuticals would mean reaching stage 2 or stage 3 testing rather than revenue rate. The typical target is acquisition in three to five years from seed round, though most end up taking longer.

On your pitch to investors, the exit strategy slide is simple:

  • a list of companies that ought to be interested in acquiring your startup
  • other startups in the same space that have been acquired
  • metrics for those acquisitions, usually expressed as a multiple of sales
  • average acquisition price in your industry as a multiple of sales

Combining this multiple with your revenue projections from the previous slide gives an estimate of the expected valuation of the company over time.

Some VCs advise against including an exit strategy slide in your pitch. The VCs who specialize in your industry will have been involved in many of the relevant acquisitions. There’s no need to tell them what they already know better than you. However, for angels and generalist VCs who don’t know your industry, and particularly for niche products in specialized industries, the exit slide is critical. We’re like real estate investors from another city. We need you to tell us about the neighborhood you’re building in so we can see if the deal makes sense. As always, adjust your pitch deck depending on who you’re pitching to.

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